Leveraged Buyouts Are About To Make A Big Comeback On Wall Street, And We Could See A $20B Deal

The leveraged buyout – a deal structure made popular during the Wall Street boom of the 1980s and again in the wake of the tech bubble – could become much more common soon, according to a report from BofA Merrill Lynch.

BofA credit strategists Hans Mikkelsen and Yuriy Shchuchinov write that current market conditions have become "unusually conductive for leveraging transactions for this stage in the typical cycle," and that as a result, "credit investors should be concerned about more extreme releveraging in the form of leveraged buyouts."

A leveraged buyout typically involves a relatively small equity investment into a takeover target, with loans that are usually multiples of the size of the equity in terms of dollar value making up the difference.

In the aftermath, companies often have to resort to stringent cost-cutting measures to service the debts that were used to execute the buyout.

The bigger the deal, the more the debt.

And the BofA strategists say they even envision deals up to $20 billion:

Clearly at this stage in the cycle we are nowhere near once again talking about Home Depot as an LBO candidate. In fact, most LBOs will likely initially be rather small – less than $5bn with a few up to $10bn in transaction enterprise value, consistent with deals seen post-Lehman.

However, in an area of historically low yields and abundant liquidity in the public markets, with banks having finally rebuilt capital, we think we have the ingredients in place for even larger deals, up to $20bn.

Markets have QE3 to thank in part for the return of the LBO, according to the report. As the Federal Reserve continues to buy mortgage-backed securities, yields grind lower, and banks no longer see most fixed-income assets as attractive investments.

Now, Mikkelson and Shchuchinov think banks will instead be forced to lend in order to make money, and that "they will also be willing to expand lending for highly leveraged transactions (as long as leverage stays below 6x per guidance from the regulators)."

The BofA strategists expand on this by noting that finding sufficient equity to put into the LBO investments will be the real limiter on deal size:

The most constraining factor for deal size appears to be equity - not debt. During the pre-Lehman environment large LBO deals were possible as private equity firms pooled resources in so-called “club deals”. Subsequent litigation makes it less likely that enough firms are willing to pool enough resources anytime soon for such mega deals, in our view.

However, the example of Synthes, discussed below, highlights that we could still potentially see a three-firm club deal for a $20bn LBO – such a deal would likely require perhaps $2bn of equity from each private equity firm. Furthermore, nothing prevents private equity from pooling resources with alternative investors such as pension funds.

Mikkelson and Shchuchinov explain that last year, when Johnson and Johnson acquired Synthes, a post-transaction SEC filing revealed that three private equity firms came together and submitted a $20 billion bid to buy out the company.

Although the consortium of PE firms ultimately didn't win the deal, the BofA strategists write that "it also makes the clear point that a $20bn LBO was feasible at the time."

Since bond yields – and thus the cost of financing a big buyout with mostly debt – have only continued to fall since the Synthes deal, Mikkelson and Shchuchinov figure the current environment has only gotten better for LBOs.